With the recent surge in home prices over the past couple of years, many taxpayers are selling their residences for significant capital gains. Under the current tax rules, when selling a primary residence:
- a married couple filing a joint tax return is allowed to exclude up to $500K of capital gain income from the house sale.
- for married filing separate, single or head of household filers, the exclusion amount is $250K.
The capital gain is the difference between your net sale proceeds (gross sales price less selling expenses such as broker commission, legal fees, stamps and other items noted on the Closing Disclosure) less your cost basis (original cost of the house plus renovation and improvement costs). As long the taxpayers have owned and lived in the house for 2 out of the past 5 years, they will qualify to exclude $500K/$250K of capital gain income from the sale of their primary residence.
A few other tax considerations when selling of your primary residence:
Your mortgage balance doesn’t impact the capital gain.
- Taxpayers are often confused with regard to how their outstanding mortgage impacts the capital gain calculation from their home sale. Actually, the outstanding mortgage balance payoff at closing does not impact the capital gain at all. The gain is simply sale proceeds less cost basis as noted above.
The home sale capital gain exclusion only applies to the sale of a qualifying primary residence and not to a second home.
- For married filing joint filers, in order to qualify for the full $500K sale exclusion, both spouses must have used the residence as their primary residence for 2 out of 5 years (i.e., if recently married with one spouse living in the house more than 2 years and the second spouse living in the house less than 2 years, then the couple will only qualify for a $250K exclusion and not the full $500K exclusion). However, only one spouse needs to meet the ownership requirement in order to claim the entire $500K exclusion.
Maintain documentation for renovations and capital improvements on your home as best you can.
- Keep a folder containing contracts that you had with builders, supply invoices, cancelled checks related to various home improvement projects done, and credit card statements showing amounts paid for renovations and improvements. As a space saver and if it’s easier for organizing your records, you can scan copies of such documents onto a disk. If ever audited by the IRS, as long as the information can be provided in a readable format, digital images and copies work as well as the original hard (paper) copies for IRS needs.
At closing, the attorney handling the paperwork will generally provide the seller with a Form 1099-S, Proceeds from Real Estate Transactions, reporting the sale proceeds of the house.
- Be sure to find this tax form in your packet of signed documents from the closing and provide a copy of the 1099-S to your tax preparer. Closing attorneys generally do not send out another copy of the Form 1099-S to taxpayers the following January, when most other tax documents are mailed to taxpayers. If a 1099-S is prepared but not reported on your tax return, you will receive a notice from the IRS showing the discrepancy and “under-reported income”.
- While the majority of home sales will fall under the $500K/$250K exclusion, we advise reporting the sale whether or not you have a copy of the IRS Form 1099-S in your records or not. If you cannot locate a copy of the 1099-S, then provide your tax preparer with a copy of the Closing Disclosure statement (CD) or HUD form to provide the sale proceeds in order to report your home sale on your tax return.
- For divorced couples who sell their jointly owned residence after a divorce is final, special provisions apply to allow both spouses to each qualify for the $250K exclusion on their separate tax returns even if one spouse does not meet the 2 out of 5 years residency requirement.
One final item to be aware of, if your residence was ever used as business property, such as a home office or rental property (including Airbnb), the allowed depreciation claimed while used for business purposes needs to be “recaptured” as income in the year of sale.
- Depreciation, for accounting and tax purposes, is defined as expensing the cost of property over a useful life when the property is used in business. When you have a home office or your residence was previously used as a rental property, you depreciate the property for tax purposes, claiming an annual business deduction for the allowed depreciation expense. When the residence is later sold, the amount of annual accumulated depreciation expense claimed on the business use portion of the house during the years of business use is considered income and is not allowed to be included as part of the $500K/$250K exclusion rule.